In the US, some states have also implemented stricter regulations and it’s now much tougher to start your own fund and keep it running.

To have a real “institutional-quality fund,” these days, the real minimum is more like $250 million USD.

Q: Wow. That seems really high.

A: It is. The days of starting in your bedroom with $1 million raised from friends and family are over, and even starting in the $20-50 million AUM range would be tough.

I’ve seen some people start with $100 million and eventually grow much bigger, but even at that level a high percentage of your fees will be eaten up by infrastructure and expenses other than employee compensation.

Many new managers do not think about the fund economics at all.

They just think, “Aha! I’m a great investor and I’ve made so much money for my firm or in my own personal account, I can easily start my own fund!”

They forget that by starting your own fund, you’re really starting your own small business – only it’s even higher-stakes and higher-pressure because there’s little-to-no tolerance for failure.

It’s most sustainable to live off management fees, so you need to do the math first and see what amount you need to pay for compliance/infrastructure/administration, your staff, and yourself (most managers, of course, don’t even take a salary initially).

The Real Cost of Capital?

Q: So this is not exactly for the faint of heart.

How do you raise capital if you have a solid investment track record, but you’re brand new and you don’t yet have connections?

A: You don’t (laughs).

It will be almost impossible to start your own fund if you’re in that position. Some people do get funded by seeder funds, but that’s the exception rather than the rule.

They also tend to give you less capital at first – getting over $100 million solely from a seeder fund would be almost impossible, so your only real shot is to start smaller than that and put in place a plan to ramp up to $100 million over 2-3 years.

Your best option, though, is to spin out of an existing bank, hedge fund, or prop desk.

You already have the team in place, you have a proven track record to point to, and you might even be able to re-use (or get discounts on) some of your infrastructure.

Q: OK, so it sounds like if you’re not in an existing team at a large fund or large bank, or you can’t get funded via a seeder, you need to reconsider your next move.

A: Well, you could still start out with far less capital than that and make it more of a “family office” – but I wouldn’t consider it a true hedge fund unless the LP structure with carried interest is in place.

Q: Right, agreed.

So let’s say that you do have a track record, you’ve worked in a solid team, and you know a lot of institutional investors and can get introduced to more through your prime brokerage provider and other connections.

How do you start marketing your new fund?

A: Before I explain that, first note that some firms won’t let you market the track record you established while working for them.

Check your employment agreement carefully to see if you can use your past performance to market your new fund. Your track record can also be problematic because you won’t necessarily have 100% ownership of it.

So the “new fund marketing process” is more about your process, your story, and who you are as a person than most realize.

Q: So what are they actually looking for in your story and process?

A: Three points come to mind:

It must be specific – if it’s something vague like “find and invest in undervalued companies,” you won’t have much luck.

It must be repeatable and it must not be dependent on specific economic conditions or a single person.

It must be understandable – institutional investors always prefer something with lower potential returns that they understand 100% over something very complex, with potentially higher returns, that they don’t fully grasp. In fact, they might be extremely skeptical of high returns (Bernie Madoff, anyone?).

The numbers become more important in proportion to the length of your track record with that specific strategy.

Q: OK, so let’s make this more specific. Can you give us an outline of a “bad” pitch to institutional investors vs. a “good” pitch?

A: Sure… a “bad,” or at least less appealing, pitch might be something like the following:

Your Story: Upcoming healthcare reform legislation set to be implemented next year has made the market less favorable for medical device companies, but more favorable for certain regional health insurance companies due to the demographic shifts in parts of the country. You believe that the market has not yet fully priced in this reform, and that many companies are undervalued or overvalued as a result. Due to funding shortfalls and the increased cost of regulation, many of the financially weaker companies will also be acquired in the near future as management teams start to recognize their new expense profiles.

Your Process: To find likely acquisition candidates that are currently undervalued by the market, you focus on 3 key geographies with misunderstood and rapidly changing demographics. Then, you pore through companies’ filings, call suppliers and medical professionals in their networks, and do patient interviews to get firsthand information on how premiums, claims, and fees might be changing over time. You also analyze the Balance Sheets of these companies to identify ones that are most likely to hit a funding shortfall and therefore turn into acquisition candidates.

Your Returns: You’ve already been doing this for 2 years in your personal account of $100K and you’ve averaged 20% returns each year, verified by a Big 4 audit.

This one might seem like a reasonable strategy, but there are several problems:

First, your story is too dependent on the current policies of the federal and state governments – what if this changes? What’s your story then? It’s always dangerous to pick something closely linked to specific policy decisions.

Second, your process is not scalable because it involves a ridiculous amount of reading through SEC filings and doing a lot of field work. It’s very labor-intensive, and you’ll probably need more analysts than you can afford with your management fees to implement this.

Finally, your returns are for a personal account and it’s unclear whether or not your strategy would work with $100 million in funds rather than $100K in funds. Many strategies work well in one of those ranges, but not both.

Q: Great. And a “good” pitch?

A: A better pitch might be:

Your Story: In certain “mergers of equals” scenarios, there is a higher likelihood of a deal going through depending on how the exchange ratio fluctuates with the stock price of the buyer or seller. There’s also a strong correlation between those criteria and the most recent earnings announcements of the buyer and seller prior to deal announcement, and how the stock traded in the week immediately after. The market has continuously mispriced the stock prices of companies with exchange ratios and other deal terms in a certain range, and you can exploit these opportunities to earn returns on par with the market, but with significantly less risk.

Your Process: To find these opportunities, you simply track M&A activity in your sectors of interest and apply a set of 15 “rules of thumb” about the exchange ratio and underlying stock prices to all companies in the set, also looking for specific numbers and points in their SEC filings. If the companies pass your initial test, you conduct additional due diligence on them and take the temperature of others in the market before investing.

Your Returns: Working in a team of 3 with $20 million in capital at a generalist hedge fund over the past 5 years, you’ve averaged 11% annual returns, always in a relatively narrow band from 8% to 15% in any given year.

This strategy is specific, not tied to a passing fad or trend, and the process is more repeatable / scalable with these criteria.

It’s also less dependent on you, and your returns have been more consistent with a much larger amount of capital over several years.

Q: An interesting “makeover,” to say the least. Did you want to add anything else about structuring your pitch for these meetings?

Have a phone conversation where they mostly ask about your strategy and get a handle on what you’re doing qualitatively.

Then, they will ask around about you in the community and determine your reputation… if they ask around and come up with nothing on you, it might be even worse than coming up with negative findings.

If they like your story and your reputation, they’ll invite you in for a day-long presentation where you present slides, go through your story, your process, how you manage risk, your team, your performance statistics, and more.

I already went through how to present your story and investment process, but I’ll stress two important points once again here:

They spend a lot of time getting to know you as a person. They want to see that you’re ethical and act with integrity.

They focus on how you deal with stress and what you do when your investments don’t go well. So do not make the mistake of focusing too much on the “upside.”

The questioning will also differ depending on your track record; someone with 15 years of experience has been through many more business cycles than someone with only 5 years of experience.

Q: Right, and so then they make a decision after this day-long presentation?

A: No, of course not – that would be too easy.

They might take up to a year to make a decision after that, and they’ll have you come in to pitch once again to a different group, ask you more questions, and then do a “site visit” where they come to your office and talk to more of your staff.

They really, really want to get to know you on a professional and personal level.

If all goes well, they might then submit a proposal on your fund to the Board of Trustees, which usually meets 4 times per year.

You pitch yourself to them, answer any questions, and then they make the “final decision”… which could sometimes be another few weeks / months away.

Consultants also play a big role in this process for both small funds and large funds – endowments and pension funds pay these consultants to find potential new hedge fund investments, and it’s their job to know everyone in the community.

There is a “size bias,” though, so if you’re under $100 million in AUM, you won’t get much attention from them.

The bottom-line: this is going to be a time-consuming, ego-bruising, and drawn-out process.

Let’s say you successfully raise capital – what’s your relationship with these LPs like over time?

A: It depends on the investor – at the minimum, you’ll send out quarterly or monthly performance updates and an annual letter (similar to Warren Buffett’s annual investor letter), but some managers will also send out case studies on specific investments they made.

You decide on the terms upfront in the investor agreement, but they also expect you to be responsive to any questions that come up. Investors will call you randomly to ask how things are going or to get you to explain the strategies you’re currently using.

In general, endowments and large funds will be much more hands-on and will scrutinize you very closely. They’ll check in with managers in between quarters, and some large funds have entire departments just for monitoring the funds they’ve invested in.

Of course, it’s in your interest to minimize the amount of information you’re required to send out – reporting just adds to the already high administrative burden, on top of all the compliance and tax paperwork.

Q: Great. Well, not great about all that administrative stuff.

So onto the strategies you use, the technical work, the hiring process, exit opportunities, and more…

About the Author

Brian DeChesare is the Founder of Mergers & Inquisitions and Breaking Into Wall Street. In his spare time, he enjoys memorizing obscure Excel functions, editing resumes, obsessing over TV shows, traveling like a drug dealer, and defeating Sauron.

Comments

Hi, quick question, I hope you are still responding to comments. Can I start a hedge fund from Africa with the operational/Investment arm based offshore Malta, Cayman Islands, etc.
In a nutshell, the administrative arm in Africa will be responsible for fundraising, managing clients, while the Offshore counterpart will be responsible for investing etc.

First, great article. I agree with JP above that it is, while sobering, quite informative. I must also, however, comment on my pet peeve: When was this article written and/or last updated? When there is time-specific information in articles such as the answer to “how have things changed since we spoke last year,” it is quite useful to have a frame of reference as to when that information is referring. I would say the same about timestamps for comments. That said, thanks for the insights, and keep up the great work!

I don’t know about that one, it is still pretty hard to reach MD level at a bank and in practice most PE firms want to recruit younger people and groom them on their way up instead. Some IB MDs leave to join smaller PE funds but it’s not as common at the larger funds.

As a firm specializing in marketing for start-up and emerging hedge fund managers, I would say that this is the most accurate description I have read yet of what marketing and asset raising is REALLY like for smaller funds.